Caveat Emptor Tag Should Hang on Every IPO Share
“The IPO of The Century”
On Thursday, 2 February 2012, Facebook announced that it was going to undertake what would amount to the biggest-ever stock market listing for a technology company. As it happens,I first heard of the news on Facebook – a sometime “friend” in my network, with whom I had irregular contact – mainly concerning his champagne importing business -posted on his wall a link to the Guardian’s live news feed covering the announcement. If my memory serves me right, back then my acquaintance described the Facebook IPO as a killer deal totally worth investing in and stated he’d gladly get a piece of that cake. For his sake I hope he abstained,since the “IPO of the century”tanked…badly.The shares issued on 17 May at the pre-float price of $38 took a downward ride and by September had lost more than half of their float value. Since then,Facebook has shown signs of hesitant recovery,with its share price generally climbing and closing at $31.30 on 10 January 2013. Despite the recent advances though, Facebook’s shares are almost 18 percent below their issue price, turning the Facebook IPO from the IPO of the century to the biggest float flop of 2012.
Do All Initial Public Offerings Lose Value?
Absolutely not, there are plenty of good performers out there – LinkedIn, Spirit Airlines, Guidewire and Zipcar all saw their share value rise after their initial public offerings. However it certainly does feel that recently we’ve been reading mainly about IPO flops,including the aforementioned Facebook IPO and other disappointments such as Zynga, Groupon and Prometheas.
To get a more general sense of how recent floats have performed,one can look at three major indices:
The Bloomberg Initial Public Offering Index (BIPO) is a capitalisation-weighted index, measuring the performance of US stocks during their first publicly traded year.
The Bloomberg Great Britain IPO Index (BEUIPOGB) does the same thing for stocks in the UK.
The FTSE Renaissance Global IPO Index (IPOSG) tracks activity in the global IPO market and incorporates a rolling two-year population of IPOs.
Using 13 January 2012 as a base date, the BIPO has advanced by 2.01 percent and currently sits at 2,1750.00 with a 52-week range of 1842.10-2500.83. In contrast, the BEUIPOGB shed 71.96 percent to 14.80 with a 52-week range of 13.75-63.46. The only substantial winner has been the IPOSG, which gained 19.76 percent and currently stands at 113.39 with a 52-week range of 91.27-113.80.
These indices paint a more global picture of the state of newly issued equities – in the US and the UK companies that went public on average saw their share price either advance slightly or decrease, while the worldwide trend was the opposite. In fact the FTSE Renaissance Asia Pacific ex Japan IPO Index, which captures the essence of IPO activity and performance in the Asia-Pacific region, rose by the impressive 22.6 percent, in the process outperforming by a long shot its Western counterparts.
In his book The Only Guide to a Winning Investment Strategy You’ll Ever Need, Larry Swedroe, principal of and director of research for The Buckingham Family of Financial Services, cited four studies of historical data which showed how different investment strategies for Initial Public Offerings performed:
The first strategy was to buy every IPO from 1970 to 1990 at the closing price on the first day of trading and then hold each for 5 years. The results showed that the IPO investments performed seven percent below the benchmark performance of companies with similar market capitalisation and already trading.
The second strategy involved buying all Initial Public Offerings issued in 1993 and holding them until mid-October 1998. According to the study, the average IPO in this group returned 67 percent less than the S&P500 index.
The third strategy was to buy every IPO which between 1988 and 1993 raised at least $20 million, a total of 1,006 IPOs. This investment bundle underperformed the Russell 3000 index by 30 percent in the three years after going public. Out of all Initial Public Offerings included in the bundle, 46 percent produced negative results in the study period.
The fourth strategy was to buy all IPOs which rose 60% or more on their opening day and then hold them from 1988 to 1995. The results – this group underperformed the market by two to three percent per month or 24-36 percent annually.
Why Are Small Investors Losing from IPOs?
Given the recent flops, there is a growing belief among retail investors that IPO actually stands for “it’s probably overpriced”. According to Chuck Jaffe from MarketWatch, the initial public offering process is built and managed in such a way as to create a predictable pop on its opening day, which later turns into a similarly predictable fall-back. This suggests the need for a new rule on the stock exchange – “When Wall Street gets excited by something new, investors should get nervous.”
The more buzz generated about an incoming IPO such as Facebook, the more retail investors get excited and ready to jump in on the opening day at what might prove to be a very inflated price per share. That inflation prospect is hardly surprising – IPOs are used both to fund the company and reward its founders and pre-float investors for their efforts and risk-taking.
Individual investors, on the other hand, seem to be the guys stuck in the back of a big road race – they might get by some of the runners in front of them but those at the starting line have already been assured a fast and easy win. The Wall Street firms and their favoured investors get to take a quick, short-term punt on huge risk-free profits on the back of inflated share prices. Whereas Joe Investor is often left relying on the “greater fool” theory – the idea that someone else at some point will come in willing to pay more.
According to Alexander Haislip, author of Essentials of Venture Capital, the time is over when the wealth created by real companies producing valuable products spreads around to anyone with savings and access to a stockbroker. The winners now are private investment firms and venture capitalists. They participate in the true round of initial public offerings – typically investing in private fast-growing companies valued at £500 million or more and then capitalising on their explosive growth by effectively assuming the role of the IPO. The Facebook IPO was not a flop for these investors – many doubled the money they put in the social network.
Haislip gives as an example the cloud storage company Box, which recently raised $125 million (£77.5 million) from private placements in order to continue its growth momentum, expand internationally and build the tools to make it more appealing to large enterprises. And a year ago, the company did an $81 million (£50 million) investment round, which valued it at around $600 million (£372 million). If this had been 15 years ago, founder Aaron Levie would have had to take his company to the public markets and Joe Investor could have come aboard and watched Box grow from a $600 million (£372 million) valuation in 2011 tothe $1.2 billion (£744 million) it’s reputedly worth today. Instead Box remains private and if and when it does go public it will have passed its high-growth phase. The winners? That would be the private equity investors, the venture capitalists and the company insiders.
The JOBS Act and How it Raised IPO-Tied Risk in the US
The US Jumpstart Our Business Startups (JOBS) Act – designed to allow companies to sell their stock to the public with less regulatory oversight – was signed into law by President Obama on 5 April 2012.
Amongst a raft of other measures, the act raised from 500 to 2,000 the number of shareholders a company needs to have to start reporting financial statements to the public. Many companies will also be able to escape some of the Sarbane-Oxley audit regulations, which were enacted in response to scandals such as Enron, WorldCom and Tyco International.Other provisions of the JOBS Act reduce the disclosure that firms must provide around a possible IPO and allow for less stringent research than hitherto. A company with less than $1 billion (£620 million) in revenues is now able to file the S-1 form necessary for flotation just 21 days before listing date, giving analysts less than a month to evaluate the company. The only participants who will have more than 21 days will be the investment banks underwriting the IPO. Additionally, the JOBS Act now allows these banks to publish their research on these smaller float prospects. This incentivises banks to optimise the offering and receive higher advising fees as a result. The JOBS Act thus makes it easier for companies to realise an IPO but arguably has also turned IPOs into less attractive investments for mainstream investors.
Ernst & Young Study – Patterns of High-Performing IPOs
In 2007 the Quantitative Economics and Statistics group of Ernst & Young performed a study which aimed to identify similarities amongst companies which successfully floated and then enjoyed strong subsequent performance. The study analysed 110 US companies which went public between January 2006 and June 2007 and which immediately qualified for listing in the Russell 2000 Index. Key findings of the study include the following:
IPOs of older companies performed better
The median year of founding for the group of 110 companies was 1998,making the companies concerned eight to nine years old. Such longevity was accompanied most often with size: companies that launched before 1995 averaged $703,000 in annual revenues compared with an average of$190,000 for younger companies. Age also lowered the risk of poor performance – some younger companies (founded 1995 or later) registered losses three months out from the IPO of up to 51.7 percent. Older companies’ losses for the first 90 days of trading never exceeded 20.5 percent.
It’s Better to be Global
More than one-third of the companies had global or at least international operations and those operations contributed to stronger performance – of the 43 percent of the Initial Public Offerings that outperformed the Russell 2000 Index as of 30 June 2007, 43 percent operated beyond the US.
Number of Institutional Investors
38 percent of those over-achievers had more than 80 institutional investors, compared with only 24 percent of underperformers. More than three-quarters of the companies with fewer than 40 institutional investors underperformed the Russell 2000 Index more than twice as often as they outperformed it.
Acquisitions helped boost trading premiums – 77 percent of the study companies which conducted a transaction after their IPO were trading at a premium as of the end of June 2007. Of companies which didn’t complete an acquisition, only 55 percent were trading at a premium.
Experience was not always positively correlated to success – 13 percent of the CEOs of outperformers were under 40 and only eight percent of the underperformers were under 40. For CEOs over 60, 15 percent were outperformers but 20 percent were underperformers.
Better paid, better performing
66 percent of the companies that outperformed provided their CEOs with a total compensation of $1 million or more, compared with 48 percent of the underperformers offering that level. Only two percent of the outperformers were paying less than $500,000 to their CEOs while 17 percent of the underperformers paid below that level. The study recognizes that total compensation packages for the period might have been affected by market performance but points out that annual salary of CEOs generally followed a similar trend.
Bad News Hurts
47 percent of the companies with no negative news released onto the market managed to outperform the Russell 2000 Benchmark compared to only 32 percent of those obliged to issue bad news. Of the companies in that latter camp, 25 percent experienced a trading loss of more than 25 percent. Only five percent of the companies that didn’t have to notify bad news had that experience.
IPOs – Rush In or Stand By?
Judging by the Ernst & Young study, the ideal company for an IPO investment needs to be eight to nine years old, have international operations and be actively in the view of institutional investors. Its CEO should be under 60 and be paid over $1 million annually. Bad news hurts Initial Public Offerings, while acquisitions can be helpful.
Of course, these yardsticks are far from being guidelines for investing in IPOs –the study highlights interesting patterns in IPOs that have performed well but that doesn’t per se translate into a concrete IPO investment strategy. Indeed, the better strategy may well be to stay out of an IPO for at least three months after its flotation and until some post-IPO quarterly earnings have been reported. As Warren Buffet said so succinctly: – “If a business does well, the stock eventually follows.” With IPOs, and especially with skitterish market conditions, there’s much to be said for waiting and seeing.